For decades, profit has been seen as a yardstick to measure business performance and growth. However, the discovery of cash flows has put profit on the sidelines. Many projects and investments are evaluated using cash flows. But is profit Important? This article will explain.
Here are five important aspects of earnings for a business
Measurement of performance
Profit is the primary measurement of performance. Companies that are making profits are seen as strong entities. It is the marked result of a business. It shows that management is efficient.
As a performance measure, profit is used with other items in the financial statements to form ratios. This ratio explains the business better. It also re reveals secrets about a business. Such as whether there is fraud or compliance with policy issues.
To illustrate, profit after tax combined with capital employed explained how efficiently the managers utilised the company's assets. Also, gross profit and cost of sales will tell us the company's earnings markup. It can also show inefficiency in a business or a lack of compliance with policy. Gross profit margin might be inconsistent month to month. This implies a lack of compliance by managers and employees with the policy that relates to profitability
For growth and development
Another importance of profit is its usefulness for growth and development. It is profit, not cash flows, that is ploughed back into the business for growth. Companies can set aside part of their earnings for research and development. It can be used for expansion. And buy back the company's shares from the listed stock exchange market.
Profit can be used to increase shareholders' wealth through rights issues. If a shareholder accepts his/her right issue, it increases their share value. The Central Bank of Nigeria recently increased the capital requirement of banks. The requirement restricts banks from using their shareholders' funds. This includes profit saved for growth and development (bonus shares, retained earnings, etc.).
The apex bank recommends paid-up capital and share premium as the recognised increase in capital. However, banks cannot issue fresh capital to investors. Why? It will dilute or reduce the value of existing shareholders' shares. To avoid this a right issue is used. So that investors who use their rights will increase shareholders’ value. The bank achieved its recapitalisation goal.
Note that the right issues are from bonus shares, and this is usually set aside from earnings after tax.
Investors’ motivation
Profit is the source of investors' motivation. How? It is a profit-making joint stock company that can declare dividends. Companies will not declare dividends because they have lots of cash. In many companies, an increase in earnings means dividend growth. Investors are motivated by dividend payments. This may encourage them to increase their shareholdings.
Means of Employee Bargaining
Employees can request salary increments by convincing management of their impact on the company's profitability. Labour unions can bargain for increased emoluments if they know the revenue growth of the company.
To understand business risk
Entrepreneurs go into business by taking risks. Most risks are two-way, profit or loss. Profit is the reward for taking risks with capital introduced to the business. Loss is the risk that occurs from the entity.
Finally, brothers, profit is important to businesses. The recognised way of measuring a company's performance is earnings. Businesses are valuable when they earn profit. Investors benefit through dividend payout when companies are doing great.